# Convertible Debt – Warrants

Earlier in the convertible debt series we talked about the “discounted price to the next round” approach to providing a discount on convertible debt. The other approach to a discount is to “issue warrants”. This approach is more complex and usually only applies to situations where the company has already raised a round of equity, but it still pops up in early stage deals. If you are doing a seed round, we encourage you not to use this approach and save some legal fees. However, if you are doing a later stage convertible debt round, or your investors insist on you issuing warrants, here’s how it works.

Assume that once again the investor is investing \$100,000 and receives warrant coverage in the amount of 20% of the amount of the convertible note. In this case the investor will get a warrant for \$20,000.

This is where it can get a little tricky. What does \$20,000 worth of warrants mean? A warrant is an option to purchase a certain number of shares at a pre-determined price. But how do you figure out the number of warrants and the price that the warrants will be at? There are numerous different ways to calculate this, such as:

1. \$20,000 worth of common stock at the last value ascribed to either the common or preferred stock;
2. \$20,000 worth of the last round of preferred stock at that’s rounds price of the stock; or
3. \$20,000 worth of the next round of preferred stock at whatever price that happens to be.

As you can see, the actual percentage of the company associated with the warrants can vary greatly depending on the price of the security that underlies it. As a bonus, the particular ownership of certain classes may affect voting control of a particular class of stock.

If there is a standard, it’s the second version where the warrants are attached to the prior preferred stock round. If there is no prior preferred, then one normally sees the stock convert to the next preferred round unless an acquisition of the company occurs before a preferred round is consummated and in that case, it reverts to the common stock.

For example, assume that the round gets done at \$1.00 / share, just like in the previous example. The investor who holds a \$100,000 convertible note will get \$20,000 of warrants, or 20,000 warrants, at an exercise price of \$1.00, to go along with the 100,000 shares received in the financing from the conversion of the note.

Warrants have a few extra terms that matter.

Term Length: The length of time the warrants are exercisable which is typically five to ten years. Shorter is better for the entrepreneur and company. Longer is better for the investor.

Merger Considerations: What happens to the warrants in the event the company is acquired? We can’t opine more strongly that all warrants should expire at a merger unless they are exercised just prior to the transaction. In other words, the warrant holder must decide to either exercise or give up the warrants if the company is acquired. Acquiring companies hate buying companies that have warrants survive a merger and allow the warrant holder to buy equity in the acquirer. Many a merger have been held up as warrants with this feature have upset the potential acquirer and thus as part of the closing requirements mandated that the company go out and repurchase and / or edit the terms of the warrants. This is not a good negotiating spot for the company to find itself in. It will have to pay off warrant holders while disclosing the potential merger (so the company will have little leverage) and at the same time will have a sword over its head by the acquirer until the issue is resolved.

Original Issue Discount: This is an accounting issue that is boring, yet important. If a convertible debt deal includes warrants, the warrants must be paid for separately in order to avoid the OID issue. In other words, if the debt is for \$100,000 and there is 20% warrant coverage, the IRS says that the warrants themselves have some value. If there is no provision for the actual purchase of the warrants, the lender will have received an “original issue discount” (OID) which says that the \$100,000 debt was issued at a “discount” since the lender also received warrants. The issue is that part of the \$100,000 principal repaid will be included as interest to the lender, or even worse, it will be accrued as income over the life of the note even before any payments are made. The easy fix is paying something for the warrants, which usually is an amount in the low thousands of dollars.

The difference between warrants and discounts is probably insignificant for the investor. We suppose if the investor is able to get warrants for common stock, then perhaps the ultimate value of warrants may outweigh the discount, but it’s not clear. As evidenced by the number of words above, warrants add a fair amount of complexity and legal costs to the mix. On the other hand, some discounts will include valuation caps (more on this in our next post) and that can create some negative company valuation ramifications. Warrants completely stay away from the valuation discussion.

Finally, in no case should an entrepreneur let an investor double dip and receive both a discount and warrants. That’s not a reasonable position for an investor to take – he should either get a discount or get warrants.

# Warrants In A Deal With An Advisor

Question: I am a startup about to receive a convertible loan investment. My friend has been advising me on an adhoc basis re. the financials on a barter basis with me. Now he’d like to formalise his agreement with the company. He has made his money as an entrepreneur and now travels alot but will be available for consultancy for us. His deal feels harsh: 1) he’d like to consult for 2 days a month at £1,000 per day. He travels alot so, this would be around his availability etc etc 2) he’d like to be paid not in cash (we can’t do this) but ‘via warrants’ priced at the same price and on the same terms as the deal done with our first round financier. He has stated that any entitlement to warrants earned cannot be revoked upon any subsequent termination of the contract by me. 3) He’d like to be a ‘commercial manager’ with a lot of involvement in the business exchanges with other professionals (something I’ve done to date) but I feel it’s too heavy-handed at this very early stage of the business. Please could you explain what ‘warrants’ mean?

Valuing his work in the first 12 months at £24,000 (2 days per months @£1,000 per day) at the same as our financier would mean he’d get approximately 5% of the company. This seems high for us. I wonder do you have any thoughts on an alternative proposition? We have raised investment for the first 7 months of business. And we’ll have to raise more immediately. To date, my friend hasn’t made any introductions here and doesn’t intend to. He sees himself more as a ‘safe pair of hands’ for investors with his background in finance. What would be a better deal to expect from a professional with this sort of experience to bring to the company?

Your friend is essentially asking for the right to invest at the same price (known as the “exercise price”) that your financier is investing in. The amount of warrants he is asking for is mathematically linked to the amount of time that he’s working based on his day rate.

While it’s a strange ask, it’s not inappropriate. Another way to look at is that he’s asking for the right to invest £24,000 in your company on the same terms as your investor. So he’s not actually getting equity, just the right to buy it at a later date. The terms associated with this matter – if the time he has to exercise the warrants is long enough (say 10 years) then it’s likely he’ll never have to shell out the money to actually buy the stock. Instead, when the company is acquired (or goes public) he’ll get the difference between the share price at that time and the exercise price of the warrant.

It sounds like your post money valuation is around £500,000 (if £24,000 is about 5% of the company). Another approach would be to simply offer him warrants for a percentage of the company that feels good to you for his contribution. If you feel 2% is adequate, rather than him earn the equity monthly, just make him a grant of 2% in warrants on the same terms but vest them monthly over a year.

# Series A Warrants Based On Milestones Versus A Deal With Two Closes

Question: In a Series A, the investor is proposing a preferred stock with warrants. The warrants relate to the accomplishment of milestones, are optional, and are priced at 50% above the initial price. Is there an advantage to this versus structuring a two close deal. How do we make the second investment mandatory, more like a call option?

Ahhh. Nothing like a complicated one to kick off the first Ask the VC question in a while. To understand this a little better, let’s break apart the questions from what is being proposed.

It sounds like the proposal is a “Preferred A” with a “warrant” for more “Preferred A” at a price that is 50% more than the initial price. In simpler terms, let’s assume that it’s a Preferred A investment of \$1m at \$1 / share (or 1m shares of stock). Let’s assume a post-money valuation of \$4m. This means that there are 3m shares of common stock since the 1m shares of Preferred buys 25% of the company.

In addition to the 1m shares of Preferred, in this deal the investor would get another 1m shares of Preferred Warrants priced at \$1.50 / share. This means that at some point in the future the investor could invest \$1.5m for another 1m shares.

Assuming there were no other changes to the capital structure, if the investor exercises the warrant there is a total of \$2.5m that goes into the company (the original \$1m plus the \$1.5m from the warrant). This buys a total of 2m shares. Since there are 3m common shares, this results in the investor owning 40% of the company for \$2.5m (2m investor shares / 5m total shares). The post money valuation after the warrant is exercised is \$6.25m (2.5m / 0.40).

Got that? Bottom line – the investor is proposing a \$3.75m pre-money / \$6.25m post-money for a total investment of \$2.5m

Now to the questions: First, Is there an advantage to this versus structuring a two close deal? Unless we address the second question, where the investor is compelled to exercise the warrant upon completion of the milestones, this is a bad deal for the entrepreneur. If the warrant conversion is optional on the part of the investor, it’s simply a pricing mechanism for capturing upside if the company is successful. If things aren’t going well, the investor doesn’t need to exercise the warrant. Depending on the actual warrant terms, the investor may have a limited time window to exercise (1 year, 2, years, 5 years) – the longer the time window, the more “optionality” the investor has. Generally, a warrant like this in an early stage investment (e.g. a Series A round) is unusual and either indicates an investor who is unhappy with the pre-money valuation and trying to capture additional economics, or is unsophisticated about typical Series A investments.

The second question is the important one. How do we make the second investment mandatory, more like a call option? The warrant should be tightly tied to milestones that the entrepreneurs believe are achievable. As VCs, we don’t like this approach, but some VCs do as they believe it focuses the entrepreneurs on what the VCs think are the hurdles (or milestones) that define near term success. If the milestones are clearly defined, achievable, and the warrant has to be exercised upon achievement, then this is merely a pricing mechanism and – as the entrepreneur – you need to decide if you are happy selling 40% of your company for \$2.5m.